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Taylor Rules in the Open Economy

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  • Campbell Leith
  • Simon Wren-Lewis

Abstract

Taylor rules which link short-term interest rates to fluctuations in inflation and output, have been shown to be a good guide (both positively and normatively) to the conduct of monetary policy. As a result they have been used extensively to model policy in the context of both closed and open economy models. A key question that arises when analysing the conduct of such policy rules in the open economy case is whether the relevant measure of inflation is the growth in output prices or consumer prices. In this paper, we show that embedding a rule specified in terms of output price inflation into a benchmark two-country model confirms the existing result that local stability requires that the response of nominal interest rates to excess inflation should be such that real interest rates rise (the Taylor Principle), but this requirement may be partially offset by raising the interest rate response to increases in the output gap. However, all the conventional results do not hold when we replace output price inflation with consumer price inflation. In this case, Taylor rules which satisfy the Taylor principle will not support a unique rational expectations path for prices and other macroeconomic variables in response to specific shocks. Our results suggest that adoption of consumer price based Taylor rules might be chronically destabilising

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Bibliographic Info

Paper provided by Business School - Economics, University of Glasgow in its series Working Papers with number 2002_14.

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Date of creation: Nov 2002
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Handle: RePEc:gla:glaewp:2002_14

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Keywords: Monetary Policy; New Open Economy Macroeconomics; Price Level Determinacy; Policy Rules;

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References

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Citations

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Cited by:
  1. Leith, Campbell & Wren-Lewis, Simon, 2008. "Interactions between monetary and fiscal policy under flexible exchange rates," Journal of Economic Dynamics and Control, Elsevier, vol. 32(9), pages 2854-2882, September.
  2. Stephen McKnight, 2007. "Investment and Interest Rate Policy in the Open Economy," Economic Analysis Research Group Working Papers earg-wp2007-11, Henley Business School, Reading University.
  3. Luis-Felipe Zanna & Marco Airaudo, 2012. "Interest Rate Rules, Endogenous Cycles, and Chaotic Dynamics in Open Economies," IMF Working Papers 12/121, International Monetary Fund.
  4. Airaudo, Marco & Zanna, Luis-Felipe, 2012. "Interest rate rules, endogenous cycles, and chaotic dynamics in open economies," Journal of Economic Dynamics and Control, Elsevier, vol. 36(10), pages 1566-1584.
  5. Fujisaki, Seiya, 2012. "Interest Rate Control Rules and Macroeconomic Stability in a Heterogeneous Two-Country Model," MPRA Paper 37017, University Library of Munich, Germany.
  6. Stephen McKnight & Alexander Mihailov, 2012. "Do real balance effects invalidate the Taylor principle in closed and open economies?," Serie documentos de trabajo del Centro de Estudios Económicos 2012-10, El Colegio de México, Centro de Estudios Económicos.
  7. Teresa Sousa, 2011. "International macroeconomic interdependence and imports of oil in a small open economy," Portuguese Economic Journal, Springer, vol. 10(1), pages 35-60, April.

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